Northern Rock

Soft-touch regulation

Mutual recrimination after a bank run does little to prevent the next one

LIKE Agatha Christie's “Murder on the Orient Express”, a whodunnit in which clues implicate all the main suspects, investigations into the sad tale of Northern Rock are turning up so many potential culprits that no one of them, it seems, can be held responsible for Britain's first bank run in more than a century. On October 9th lawmakers quizzed Sir Callum McCarthy and Hector Sants, the bosses of the Financial Services Authority (FSA), Britain's financial regulator and supervisor of its banks. With public money underpinning Northern Rock, parliamentarians wanted to know who had let the bank get into such a sorry state, and who managed its bungled rescue. Instead they were led on a merry dance through the Kafkaesque world of bank supervision, in which fiasco marks success, no one is in charge of anything and the net of culpability is cast meaninglessly wide.

Sir Callum and Mr Sants, although owning up to some shortcomings and promising to learn from their mistakes, variously blamed the bank's managers, the deposit-protection scheme and, finally, the central bank. Mervyn King, the governor of the Bank of England, mounting a spirited defence elsewhere that day, blamed regulators (in other words the FSA), the law and “the actions of the authorities [which] seemed, at least initially, to fan the flames”. On October 11th Alistair Darling, the chancellor of the exchequer, told Parliament that he would review the framework for supervising and rescuing banks, and push for more cross-border co-operation. But he is missing the main culprits: Britain's unsatisfactorily divided regulatory structure, and its famous light touch.

Start with that structure, which dates from the government's decision in 1997 to grant the Bank of England independence in monetary policy while removing responsibility for bank supervision to an emerging all-purpose financial regulator. Although not without its fans, this scheme had two dangerous consequences.

The first is that it divided information about what was happening in money markets (monitored by the central bank) from information about what was going on inside individual banks (overseen by the FSA). And it gave the organisations conflicting goals. The FSA is reluctant to let banks go bust on its watch, yet it cannot throw them a lifeline. The central bank, in contrast, can rescue banks by giving them access to money (with the agreement of the chancellor). But it may be able to tolerate a bank collapse, on the grounds that a little bloodletting today forestalls a massacre tomorrow.

A second issue is the FSA's legendary light touch, which has helped to attract footloose financiers to London and made it the world's biggest international financial centre. But this has some unintended results. In a paper in 2005, Howell Jackson, of Harvard Law School, reckoned that whereas the main aim of American financial regulation was to protect consumers, British regulation was more preoccupied with the smooth functioning of markets and keeping costs down. Elaborated rules have steadily given way to principles, and only the riskiest firms (or those most likely to make a large splash if they go bust) routinely get heavy-duty scrutiny.

In wholesale markets this approach has worked well. It is also cheap. Elizabeth Brown, an expert in regulatory law at the University of St Thomas in Minneapolis, calculates that whereas America's banking system (measured by total assets) is only a little more than twice as big as Britain's, the government spends 60 times more on regulation than Britain does.

It is less clear, however, that regulators should content themselves with a light touch where banks are concerned: the savings of retail depositors are ultimately guaranteed by the taxpayer; and problems at one bank can spread quickly through the financial system. Hands-off regulation can work only when those being regulated know they may actually go bust if they misjudge the risks they are taking. In supervising banks, the FSA's touch begins to look less light than soft.